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Social Security Benefits Up-rating Order 2011

My Lords, I also speak to the draft Guaranteed Minimum Pensions Increase Order 2011. I am satisfied that the orders are compatible with the European Convention on Human Rights. The Guaranteed Minimum Pensions Increase Order provides for contracted-out defined benefit schemes to increase their members’ guaranteed minimum pensions that accrued between 1988 and 1997 by 3 per cent. Such increases are in line with the growth in prices or 3 per cent, whichever is the lower. The uprating order embodies two notable changes this year. This is the first uprating after the restoration of the earnings link for the basic state pension, and the order introduces a clear and consistent approach to price measurement with the move to the consumer prices index, thereby putting the annual uprating of social security benefits on a sustainable footing for the future. I know that noble Lords will welcome the coalition Government’s immediate fulfilment of the promise to restore the earnings link for the basic state pension. Not only that, but we have also given a triple guarantee which means that the basic state pension will be increased by the highest of earnings, prices or 2.5 per cent. As a result of those actions, it is estimated that the average person retiring on a full basic state pension in 2011 will receive £15,000 more in basic state pension income over their retirement than they would have done under the old prices link. Through these policies for the basic state pension, we will provide a solid financial foundation for people’s retirement income. The basic state pension goes to more than 11 million pensioners in this country, and is the most efficient and equitable vehicle for distributing resources to pensioners. From this April, the standard rate for the basic state pension will increase by 4.6 per cent. That means an increase of £4.50 a week, taking the weekly rate from £97.65 to £102.15. This is in line with a promise made at the Budget to increase the basic state pension in line with the retail prices index in 2011. In subsequent years the triple guarantee, with the consumer prices index used to measure prices, will apply. In the other place, there was an accusation that we have had to override the triple guarantee this year because the relevant CPI figure—3.1 per cent—would have resulted in too low an increase. This is not the case. We made a promise to increase the basic state pension in line with the RPI in April 2011 if it showed the highest growth. It did, so that is what we are doing. There is no override here; we are simply fulfilling a promise. We have also ensured that our poorer pensioners see the benefit of the increase in the basic state pension by ensuring that the standard minimum guarantee in pension credit rises by at least the cash increase for the basic state pension this year. Therefore, from April 2011 single people on pension credit will receive an above-earnings increase to their standard minimum guarantee of £4.75, which will take their weekly income to £137.35. For couples, the increase will be £7.30, taking their new total to £209.70 a week. I will now turn to the second notable change I mentioned; namely, the switch to the consumer prices index as the measurement of prices for benefit andpension uprating. This is not the first occasion on which we have discussed the CPI and it will not be the last. Indeed, we will be returning to it tomorrow in our deliberations in Grand Committee on the Pensions Bill. Nonetheless, I hope noble Lords will permit me to take this opportunity to outline our thinking on the matter again. It has been said before but bears repeating that the purpose of the annual uprating exercise is to ensure that the purchasing power of social security benefits is protected against inflation. It is not to give the highest increase possible. We believe that the CPI is the most appropriate measure of inflation and one that is fair to the taxpayer. As the Chancellor announced at the Budget, the move will save almost £6 billion a year by 2014-15. We do not claim that it is a perfect measure of inflation, but it is the most appropriate and is the measure used by the Bank of England to measure the general level of price inflation. The key difference between the RPI and the CPI is the so-called formula effect. Put simply, the CPI is calculated in a way that takes account of the choice available to consumers who can trade down to, or, in the jargon, substitute cheaper goods when prices rise. RPI is not and arguably overstates inflation as a result. A basic principle of economics is the law of demand, which states that, all other factors being equal, a rise in the price of a good will cause consumption to fall and vice versa. A key driver of this is substitution: as prices rise, consumers will substitute away from higher-priced goods, choosing less costly alternatives. Substitution can occur in different forms. There can be substitution among brands or types of products, such as brands or types of ice cream; across different store outlets and across time. This is known as elementary or lower-level substitution. There can also be substitution among items in different product categories—such as between ice cream and cupcakes, or bus rides and train rides—referred to as substitution at higher levels of aggregation. The geometric mean in the CPI is used only at the elementary aggregation, or lower level. There is no higher-level substitution assumed. A good way to think about substitution is to employ the concept of elasticity. Price elasticity is a measure of how responsive demand is to changes in price. Higher-price elasticity means that small changes in price lead to a large shifts in demand and vice versa. Where a good is described as having unit elasticity, a 1 per cent rise in price will lead to a 1 per cent fall in consumption and vice versa. This is a common way to represent demand behaviour in economic literature, in the form of the Cobb-Douglas utility function. For a given basket of goods, the Cobb-Douglas function assumes a unit elasticity of demand for all goods in the basket. How does this relate to the geometric mean? Economists have shown that the geometric mean is an exact reflection of the cost of living if the elasticity of substitution is equal to one; that is to say, if a 1 per cent change in price leads to a 1 per cent change in consumption. The arithmetic mean is appropriate if the elasticity of substitution is equal to zero; in other words, if price change has no effect on consumption. Clearly, there are some goods for which price change will have little or no effect on consumption, because there is no recourse to a substitute good which has increased less in price. One example would be petrol. That is why the arithmetic mean is used in the CPI to combine petrol prices. In fact, the arithmetic mean is used in 30 per cent of the CPI’s basket of goods for precisely that reason. Other goods it covers include electricity, newspapers, transport and postal services. What about the remainder of the index, the 70 per cent where substitution is implied by the use of the geometric mean? Do people really substitute away from goods which have risen sharply in price to those which have not? Is the geometric mean appropriate? Noble Lords will not be surprised to find that there is a body of empirical evidence that people do substitute and that the geometric mean is an appropriate reflection of that. In Australia in 2009 a study by Ivancic, Diewert and Fox found that, in the overwhelming majority of cases, elasticity of substitution was much closer to one than to zero and therefore that the geometric mean was a more appropriate reflection of consumer behaviour. One of their key findings was that consumers are very responsive to price changes at the elementary aggregate level, the level on which the geometric mean operates. However, the study went further, finding that even the geometric mean might not fully capture substitution, with some elasticities exceeding one. There is separate evidence, for example, that brand-level elasticity is often more in the one and a half to two range. Closer to home, also in 2009, the Scottish Government published an overview of evidence on food prices. Within this, the use of TNS Worldpanel market data showed that consumers do respond to higher food prices by substituting within a general category of food. I hope that this reassures noble Lords that consumers do substitute when prices rise; not necessarily that they substitute all the time, for the geometric mean does not demand that; simply that some people will substitute when an item has risen sharply in price and there is a good substitute. The CPI deals only with substitution on the elementary aggregate level, the lower level. In the United States a widespread view developed that their consumer prices index was overstating inflation by not taking account of substitution behaviour. The US Advisory Commission to Study the Consumer Prices Index, also known as the Boskin commission, was concerned about substitution bias—concerned that their CPI was overstating inflation by not taking into account consumer substitution. However, the commission’s report made the point that higher-level as well as lower-level substitution was an important part of consumer behaviour. Suffice to say that the theory and evidence for consumer substitution is compelling, that the geometric mean is an appropriate method of capturing that behaviour and therefore that the CPI’s method of aggregation is superior. That is why the geometric mean is used in the consumer prices index of the United States, Canada, Australia, Denmark, Finland, Ireland, Italy, Luxembourg—I could go on; I will go on—France, Portugal, Spain, Sweden and Austria. You get the picture. Once we accept that the use of the geometric mean, where appropriate, is superior, then we have accounted for most of the gap between the CPI and the RPI. In fact, it has accounted for an average 0.53 percentage points of the average 0.88 percentage point gap since 1997, or 60 per cent of the gap. Already it seems that the CPI is the more suitable index. People tend to gloss over the fact that most of the gap is contributed by methodology, which experts agree is superior, and concentrate on the basket of goods instead, so it is to that factor that I will now turn. The CPI excludes mortgage interest payments, which are not relevant to the majority of pensioners and benefit recipients. Only 7 per cent of pensioners have a mortgage, and many working age benefit recipients can get help with their housing costs. As noble Lords will know, it was mortgage interest that caused the RPI to fall in 2009 and, consequently, many pensions to be frozen. Without mortgage interest, the RPI would have grown 1.3 per cent rather than fallen 1.4 per cent in the relevant period. The CPI grew by 1.1 per cent in that same period. This illustrates the significant effect that mortgage interest can have on RPI inflation, and it is not a cost relevant to most benefit and pension recipients. There are other housing costs, of course—rent, for example—but, since the CPI already includes rent, we need not concern ourselves with that. What about owner-occupiers though? The ONS is working on incorporating owner-occupier housing costs in the CPI. It is not something that can simply be dropped in, and the work is currently at an early stage. We will monitor this work closely and look seriously at the new index when it is close to production. In correspondence with the UK Statistics Authority, the Royal Statistical Society has made some suggestions with regard to the CPI. Naturally, we welcome the ONS’s continuing statistical development programme. However, let us not lose sight of the fact that the Royal Statistical Society has issues with the RPI, to which I shall return in a moment. Increases in line with the growth in the CPI maintain benefit and pension value as well as putting the system on a more sustainable footing, allowing the Government to focus help where it is needed most. In short, it is fair to recipients and to the taxpayer. I mentioned the Royal Statistical Society. You will often see reports of its concerns with the CPI in correspondence to the UK Statistics Authority. Have any of those reports mentioned its repeated calls for the RPI’s methodology to be improved, given that it arguably overstates inflation? I suspect not. The Institute for Fiscal Studies’ report on the Budget said that the CPI’s methodology was, "““a sound rationale for the switch””." For a final word on the CPI, let us look no further than that longstanding Chancellor, Mr Brown, who said: "““It is more reliable ... It is more precise””.—[Official Report, Commons, 10/12/03; col. 1063.]" That is the consumer prices index—not a perfect index, but more reliable, more precise and more appropriate. I commend these orders to the House. I beg to move.